Should Banking Be Made Boring? - An Indian Perspective - আরবিআই - Reserve Bank of India
Should Banking Be Made Boring? - An Indian Perspective
Dr. D. Subbarao, Governor, Reserve Bank of India
delivered-on নভেম্বর 25, 2009
I. Introduction First of all, my grateful thanks to the Indian Merchants’ Chamber and the Institute of Chartered Accountants of India for inviting me to be the Chief Guest at this year’s International Finance and Banking Conference. The theme of this conference, “Banking - Crisis and Beyond” is relevant and timely. The global financial system has been engulfed in possibly the deepest crisis of our time shaking our world view of the financial sector to its roots. As attention both around the world and here in India shifts from managing the crisis to managing the recovery, the importance of consolidating the lessons of the crisis and reflecting them in our forward plans can hardly be overemphasized. Being at this conference and sharing some thoughts and ideas with you is therefore an opportunity to which I attach a lot of value. II. Calls for Making Banking Boring 2. Banks have been at the heart of the global financial crisis and bankers are widely seen as being responsible for the crisis. Quite understandably, there is a deluge of ideas and suggestions on reforming banks, banking and bankers. One of the more influential ideas, one that has generated a vigorous debate, has been the thesis put forward by the noted economist and Nobel Laureate Paul Krugman that the way to reform banking is to once again make it boring.3. Taking a long term historical view, Krugman argues that there is a negative correlation between the ‘business model’ of banking and economic stability. Whenever banking got exciting and interesting, paid well and attracted intellectual talent, it got way out of hand and jeopardized the stability of the real sector. Conversely, periods when banking was dull and boring were also periods of economic progress. 6. Closer home, another equally influential voice - Dr. Y.V. Reddy, former Governor of the Reserve Bank of India - weighed in on the issue. In his Guhan Memorial Lecture last month, Dr. Reddy called for ‘back to basics’ in banking and urged that banks must curb the tendency towards further financialization of deposits they mobilize and must focus instead on lending to real sectors of the economy, particularly agriculture and the small and medium industries, that have limited ability to tap the capital markets. 7. Although neither Governor King nor former Governor Reddy mentioned ‘boring banking’, in a sense both of them were calling for what can stylistically be interpreted as boring banking. 8. Krugman’s thesis of ‘boring banking’ is interesting, but also debatable. It raises several important questions. What were the ills of the banking system that caused the crisis? Is making banking ‘boring’ a necessary and sufficient cure to those ills? How do the several proposals on the table at the international level for reforming banking measure up to the test of making banking boring? And, how relevant is the ‘boring banking’ perspective in India? I want to use the platform of this conference that you have so kindly provided me to address these questions. III. Ills of the Banking System That Caused the Crisis 9. Let me turn first to the ills of the banking system that caused the crisis. I will not go into an extensive analysis of the causes. I will attempt something much more limited - just give a brief synopsis to provide a backdrop for the ‘boring banking’ discussion. Glass - Steagall Act, financial innovation and risk transmission 10. Many believe that the genesis of the crisis can be traced to the repeal in the United States in 1999 of the Glass - Steagall Act which mandated the separation of commercial and investment banking to protect depositors from the hazards of risky investment and speculation. The repeal opened up opportunities for commercial banks, investment banks, securities companies and insurance companies to consolidate, setting off a wave of innovation. Complex financial products were created by slicing and dicing, structuring and hedging, originating and distributing, all under the belief that real value could be created by sheer financial engineering. The system was characterized by opacity and dissipation of information with no one having a full picture of the extent of risk, how it was getting transmitted across the system and where it resided.Globalization of financial institutions and services The moral hazard of ‘too big, too important to fail’ institutions 13. The lure of profits encouraged financial institutions to expand, transcending borders and business segments, to exploit economies of scale and scope. And this was facilitated by the implicit faith of the authorities in ‘light touch’ regulation. Consequently, what we ended up with was large financial conglomerates with footprints across the system. These institutions knew that their failure would result in a systemic collapse, and that they would therefore be rescued at public cost. This acted as a perverse incentive for them to take on risks that we now know were imprudent if not reckless. The moral hazard of ‘too big to fail’ is therefore reckoned as one of the prime causes of the crisis. Compensation and perverse incentives 14. Finally, the asymmetric compensation structures in many financial institutions encouraged risky behaviour. The variable components of compensations were anchored to short-term profits, were one sided (high in good times and at worst zero in bad times) and had little or no risk adjustment. This myopic attitude towards long term risk provided perverse incentives to bank managements to maximise their current compensations at the cost of shareholders, and to maximise leverage without regard to the tail risks to the institution.IV. Is ‘Boring’ Banking a Necessary and Sufficient Solution? 15. The ills of the banking system listed above raise two follow-on questions. Is making banking boring in the sense that Krugman indicated a necessary and sufficient solution to curing those ills and preventing their recurrence? And what will be the cost of making boring? Both questions cause much confusion, the first because it has too many answers and the second because it has too few. Abstracting from these answers, I will argue that it is neither possible nor desirable to make banking boring. 16. The narrow banking of the 1950s and 1960s was presumably safe and boring. But that was in a far simpler world when economies were largely national, competition was sparse, pressure for innovation was low, and reward for it even lower. Bankers of the time, it is said, worked on a 3 - 6 - 3 formula: pay depositors 3 per cent interest, lend money at 6 per cent and head off to the golf course at 3 pm. From the 24/7/365 perspective of today, that may appear romantic but is hardly practical. 17. The boring banking concept does not appear persuasive even going by more recent evidence and on several counts. First, recall that during the crisis, we saw the failure of not only complex and risky financial institutions like Lehman Brothers but also of traditional banks like Northern Rock. What this demonstrates is that a business model distinction cannot be drawn between a utility and a casino; and if it can, it does not coincide with the distinction between what has to be safe and what need not be. Second, in an interconnected financial sector, how can a ‘boring’ bank realistically ring-fence itself from what is happening all around? Let us say a large investment bank, a casino if you will, fails. Because of the inevitable interconnectedness, that will cause a break down of trust not just in that particular bank but in the entire financial sector. So utilities cannot expect to insulate themselves against the risks being taken by the casinos. Third, the co-existence of utilities and casinos can also open up arbitrage opportunities. During ‘tranquil’ periods, financial institutions with higher risk and reward business models will wean away deposits from narrow banks. But when problems surface and stresses develop in the financial sector, the position will reverse with the deposits flowing back into the so called ‘boring banks’ triggering procyclicality. Finally and most importantly, what will be the cost of boring banking in economic terms? Does restraining banking to its core function just to keep it safe not mean forgoing opportunities for growth and development?18. There have of course been problems in the way banking evolved around the world - problems that were at the heart of the crisis. But clearly the answer is not to adopt Luddite solutions that take us back decades. The solution is to look ahead to what we need. We need to build institutions that go beyond narrow banking and provide the whole gamut of financial services to meet the needs of customers, markets and economies. We need to build on the innovations of the last few decades but in doing so build in also correctives based on the lessons of experience. We need to build a safe and enterprising banking sector that supports growth while preserving financial stability. We need to nurture financial markets and institutions within clearly defined and effectively supervised boundaries. Doing all of this is the basic thrust of the international reform agenda currently under discussion to which I now turn. V. International Reform Initiatives - Will They Make Banking Boring? 19. The reform initiatives in the wake of the crisis are intended to rein in the ‘irrational exuberance’ of the banking sector, keep it safe and healthy, and make banking an aid for growth and macroeconomic stability. What is relevant to our discussion here is that none of these measures is aimed at making banking boring; on the contrary, several of them will likely make banking more challenging and thereby spur innovation of a more value adding and sustainable variety. In order to enable an appreciation of this, let me provide a brief synopsis of the various initiatives under discussion from the macro and micro perspectives. The Macro Perspective 22. A somewhat original idea proposed by Prof. Raghuram Rajan, currently under discussion, is to require institutions to maintain ‘contingent capital’ to tide over systemic crisis or idiosyncratic problems. This proposal will potentially require banks to issue long-term debt instruments that would automatically covert to equity under specific triggers. This contingent arrangement will accordingly enable banks coming under stress to quickly buffer their capital without imposing any cost on tax payers. All this will not, of course, be costless. The challenge is to design the contingent capital provisions in a way that optimally manages the trade off between higher cost and lower moral hazard. 23. An important proposal aimed at mitigating systemic risk is to impose a systemic risk capital surcharge on institutions that pose a higher risk to the system because of their size, complexity or interconnectedness. There is increasing support for such a measure. In fact, Lord Turner, Chairman of the UK Financial Services Authority, went further and argued that should such a capital charge prove insufficient, there should be no hesitation in levying a tax on specific financial transactions. The Turner proposal is based on the premise that regulation should ensure that the financial sector remains within its “socially useful” size.24. Large, interconnected and complex institutions will be subject to additional regulatory obligations in other dimensions as well. Importantly, such institutions will be required to institute more sophisticated risk management systems, have robust contingency plans and put in place ‘living wills’ that can steer the course of their orderly exit should problems in these institutions become unmanageable. The Basel Committee on Banking Supervision (BCBS) is working on resolution mechanisms for cross border financial institutions with an aim to containing risk. 25. There is a proposal to move OTC derivatives to central counterparties and charge differentiated capital for OTC derivatives that are cleared on a bilateral basis. This will contain systemic risk to some extent. 26. Another lacuna that came into sharp focus during the crisis is that while financial activity is increasingly getting international, regulation remains fiercely national. The growing cross border nature of banking and banking services underscores the need for a coordinated oversight of banking entities, particularly of large and complex institutions. In an ideal world, we would have global regulation; because we are in a less than ideal world, we are having to settle for a ‘global framework’ that will mandate minimum consistency across jurisdictions in regulatory principles that would apply to similar markets, institutions, activities and products. The Micro Perspective 29. First, to ensure that bank exposures are adequately and sufficiently covered by capital, various enhancements to the Basel II capital framework have been finalised. These specifically relate to higher capital requirements for trading book to minimize the opportunity for regulatory arbitrage between the trading and banking books. There are also proposals on the table for improving the quality of capital to ensure that regulatory capital is comprised largely of elements having a true loss absorbing capacity in a going concern scenario. 30. Second, recognising that solvency of banks can be threatened by illiquidity as much as by inadequate capital, work is currently under way to develop a global standard for liquidity risk regulation of cross-border banks, and strengthening information sharing on liquidity risk among home and host country supervisors. VI. Boring Banking - An Indian Perspective 33. Let me now turn to Indian banking. The decade of the 80s and 90s and the first decade of this century saw several financial crises around the world, many of them centred in banks. These crises were sometimes country specific, often regional, and in the case of the current crisis, global in scope. And in each case, the banking sector became a drag on the real economy, jeopardized public finances and hurt economic growth. What is noteworthy though is that even as other countries and other regions went through banking upheavals, Indian banking remained safe. This is a reflection, in part of our cautious and prudent regulation, and in part of the relatively lower globalization of our banking sector. 41. The Eleventh Five Year Plan targets increase in infrastructure investment from around 5 per cent of GDP in 2006/07 to 9 per cent by 2011/12. This translates to cumulative infrastructure investment over the Plan period of over Rs. 20 trillion (US$ 520 billion). Almost one half of this investment is to be funded through debt, and as much as 43 per cent of this total debt requirement (21 per cent of overall planned investment) is planned to be financed by banks. We have to await the mid-term appraisal of the Eleventh Plan for an update of the above numbers. Regardless of any revision the numbers may undergo, what is clear is that the financing needs of our infrastructure are huge. Fourth Challenge: Further Improvements in Efficiency 50. Let me now turn to the fourth and final challenge on my list which is the challenge of further improving the efficiency of banking. But before I look ahead, I need to look back a little. The growth acceleration of the Indian economy during 2003-08 is attributable to a host of factors. Some of these are tangible such as the deregulation of the industrial sector, liberalization of external trade and external finance, reform of direct and indirect taxation and elimination of controls on doing business. Some of the factors that contributed to growth are intangible such as improved productivity, higher efficiency and growing entrepreneurism. We often forget to add to this list the contribution made by the financial sector by way of larger and better quality financial intermediation that raised the level of aggregate savings and channelled them to investment. Just one statistic will evidence this - bank credit as a proportion of GDP nearly doubled from 29 per cent in end-March 2000 to 56 per cent at end-March 2009. Even more notable, this rapid expansion of credit has been accompanied by a significant improvement in asset quality which is now close to international norms.51. The analysis in the Reserve Bank’s Report on Currency and Finance 2006-08 shows that the Indian banking sector has recorded an impressive improvement in productivity over the last 15 years; many of the productivity/efficiency indicators have moved closer to the global levels. The Report also shows that the performance of public sector banks has converged with that of new private sector and foreign banks. More interestingly, contrary to popular perception, there is also no significant relationship between ownership and efficiency - the most efficient banks straddle all three segments - public sector banks, private sector banks and foreign banks. 52. Improvement is a never ending business, and there are several tasks on the way forward. The intermediation cost in India is still high, largely due to high operating costs. Non-interest sources of income constitute a very small share in total income of banks in India. Although overall efficiency and productivity have improved, resources are not being utilised in the most efficient manner. There is a degree of stickiness and non-transparency in bank lending rates. 53. The challenge for Indian banks, therefore, is to reduce costs and pass on the benefits to both depositors and lenders. This will involve constantly reinventing business models and designing products and services demanded by a rapidly growing and diversifying economy. As we noted earlier, in the wake of the crisis, there are proposals at the global level to mandate higher capital standards, stricter liquidity and leverage ratios and a more cautious approach to risk. Admittedly, all these safeguards are necessary, but they will also raise the banks’ funding costs. What this means is that Indian banks will need to improve efficiency even as their costs of doing business go up. This is a challenge that will test ingenuity, perseverance, ability to learn and adapt and management skills. And this is going to be anything but boring.VII. Conclusion 54. Let me now conclude by summarizing the issues that I have addressed today. I have referred to the debate generated by Prof. Krugman’s thesis that ‘exciting’ banking will make for an unsafe and unstable financial system and that an important preventive against future crises is to restore boring banking. 55. I have argued that making banking boring is neither a cure to the ills that the banking system was plagued with before the crisis nor an appropriate path for the future of banking. Banking has to evolve, grow and innovate in response to the developments in financial markets and institutions. The excitement lies in responding to the challenges that this growth brings. 56. From an Indian perspective, what banks do and how well they do it is going to be central to accelerating and sustaining our growth momentum. In particular, I have referred to four challenges that the banking sector has to meet head on - deepening financial inclusion, financing infrastructure, strengthening risk management and improving efficiency. These are formidable challenges, and meeting them is going to be an exciting, rewarding and fulfilling opportunity. Perish the thought of Indian banking ever getting boring. |